Posts from September 2008

I received a bunch of requests yesterday to address Jason Calacanis’ "startup depression" email that was sent out over the weekend. Alley Insider had the full text of it online but they took it down yesterday, apparently at Jason’s request. Fortunately Jason also chose to put it up on his blog so we can all read his thoughts. Thanks Jason.

I think Jason’s email is a great "wakeup call" for everyone in the startup business. Life is going to get tougher for everyone in the US and possibly in all parts of the world that are tightly linked to the US economy. I think startups fall into that description no matter where they are based.

I particularly like Jason’s "10 specific things you can do" section. In that section he urges entrepreneurs to get focused, get better, get leaner, and ultimately to get profitable. That’s spot on.

But I do think Jason’s missing one important point in his email. It’s not the venture backed startups that are going to struggle the most. Jason wrote:

It’s my believe that the economic downturn will be much worse than it is today, and that 50-80% of the venture-backed startups currently operating will shut down or go on life-support (i.e. 3-4 folks workingon them) within the next 18 months.

Make a list of every Web 2.0 startup to raise an A or B round and cross 80% of them off the list, because they will not make it to their next round of funding or profitability.

All startups are going to have to batten down the hatches, get leaner, and work to get profitable, but the venture backed startups are going to get more time to get through this process than those that are not venture backed. Here’s why.

Venture capital firms are largely flush with capital from sources that are mostly rock solid. If you look back at the last market downturn, most venture capital firms did not lose their funding sources (we did at Flatiron but that’s a different story). If you are an entrepreneur that is backed by a well established venture capital firm, or ideally a syndicate of well established venture capital firms, then you have investors who have the capacity to support your business for at least 3-5 years (for most companies).

Venture capital firms will get more conservative and they will urge their portfolio companies to do everything Jason suggests (and more), but they will also be there with additional capital infusions when and if the companies are making good progress toward a growing profitable business.

If you go back and look at the 2000-2003 period (the nuclear winter in startup speak), you’ll see that venture firms continued to support most of their companies that were supportable. The companies that were clearly not working, or were burning too much money to be supportable in a down market, got shut down. But my observation of that time tells me that at least half and possibly as much as two/thirds of all venture backed companies that were funded pre-market bust got additional funding rounds done post bust.

So if you run or work in a startup company that is backed by well established venture capital firms, take a brief sigh of relief and then immediately get working on the "leaner, focused, profitable" mantra and drive toward those goals relentlessly.

If, on the other hand, you are just starting a company, or have angels backing you, or are backed by first time venture firms that are not funded by traditional sources, then I think you’ve got a bigger problem on your hands. It’s not an impossible problem to solve, but you have to start thinking about how you are going to get where you want to go without venture funding.

I say that because in down market cycles, it’s the seed and startup stage investing that dries up first. It happens every time. Seed/startup investing is most profitable early in a venture cycle and late stage investing is most profitable late in a venture cycle. It makes sense if you think of venture capital as a cyclical business and it is very cyclical. Early in a cycle you want to back young companies at bargain prices and enjoy the demand for those companies as the cycle takes hold. Late in a cycle you want to back established companies that need a "last round" to get to breakeven and you can get that at a bargain price compared to what others paid before you. I’ve been in the venture capital business since 1986 (that was a down cycle) and I’ve seen this happen at least three times, probably four times now.

There’s another important reason why seed and startup investing dries up in down cycles. Venture firms don’t need to spend as much time on their existing portfolio companies when things are going well. A rising market hides a lot of problems. But when things go south, they tend to become inwardly focused. I believe we are headed into a period where venture firms will spend more time on their existing portfolio and less time adding new names to it.

This has gone on longer than I generally like in a post. So I’ll end by saying that I don’t think we are in a "depression" in startup land. We are in a down cycle driven by a bad global economy. I think the web and information technology is one of the few bright spots in an overall gloomy economic outlook. So if you are working on a web technology company, be happy that you aren’t working for a bank, a brokerage firm, an automobile company, or in many other industries. The tools and services that are made in the web technology business are only going to increase in demand over the next five years. But we are going to have to service that growing demand with leaner and more focused businesses and it’s time to start thinking more about profitability and how you are going to get there.

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Dave McClure runs a very cool conference called Startonomics. It’s unlike anything else I’ve ever seen done in the conference business.

Startonomics is all about instrumenting your startup business and using measurable metrics to determine how you are doing. It’s about using numbers to improve your marketing, your product, and your business.

It’s happening this Thursday, Oct 2nd, in San Francisco. I’d encourage anyone who is based in the bay area and doing a startup to attend. It’s affordable (students for $195, entrepreneurs for $295). Register here.

Dave has graciously offered 2 free passes to AVC community members. I’ll give one each to the two best comments with a quick (twitter size) comment about how you use startonomics to run your business. Comments have to be in by 5pm eastern today.

For those readers who are in NYC and wish they could attend one of these, Dave has promised us he’s going to try real hard to do one here next year. I can’t wait.

UPDATE: Chachra and Khawk are the two winners. It wasn’t easy but I liked the brevity with which each of them outlined their approach to startonomics. Chachra said "Use startonomics to build what people need, measure what they want and
and deliver what they don’t know they need! Iterate & $profit :)".  I love iterate and profit. It’s right on. And Khawk introduced a new c-level position, the CBO – Chief Burnrate Officer. Very nice!  I also think both of them are in SF (a guess) and hope they’ll actually use the free passes. Thanks again to Dave for providing them.

My partner Brad has a good post up on the Union Square Ventures blog this morning. He’s been thinking about why a lot of the innovation in information technology is happening in consumer facing web services. He notes that:

In the old days, electrical engineers focused on getting computers
to work not on getting people to engage with the systems built on top
of those computers. The folks that built enterprise software were
vaguely aware that their systems had to be accessible to the humans
that used them but they had a huge advantage. The people who used them
did so as part of their job, they were trained to use them and fired if
they could not figure them out.

Today, no one tells you to use Facebook. There are no employer
sponsored training sessions on the use of del.icio.us. The burden is on
the designer of the system to meet a need, entertain, or inform their
users. They also have to seduce those users, hiding complexity,
revealing one layer at time, always enticing, never intimidating, until
the user one day finds they are intimately familiar with power and the
pleasures of the service.

There’s more and if you want to read the whole post, click here.

I got caught up last night and this morning on the splurge legislation. My favorite summary was from Henry on Clusterstock.  In that post, Henry wrote:

The Treasury has complete discretion over the prices it pays
for crap assets (the most important provision in the whole document as
far as the taxpayers are concerned). "The Secretary make such
purchases at the lowest price that the Secretary determines to be
consistent with the purposes of this Act." Translation: If the banks
persuade me they won’t sell for anything less than a sweetheart price,
I can give them that price. The only good news: The Treasury has to
publicly detail the prices it pays. So if the Treasury is paying
grossly inflated prices, the taxpayer has a chance of finding out about
it.

I was very happy to see that part about public disclosure. The pricing of the splurge transactions is what many of the smarter people I know have been focusing on. Paulson was very careful in his testimony to be vague about this very point. They want the flexibility to pay what they need to pay for these "crap assets" as Henry calls them.

One person’s crap asset is another person’s bargain. And I believe that, like with the RTC, many investors will make a killing buying these crap assets. This was my favorite comment in the entire discussion of the splurge on this blog last Friday (and what a great discussion it was/is). In that comment, JLM says:

Sometimes a bit of historic perspective is useful in trying to deal
with TODAY. Remember that quote about being doomed to relive the
history we ignore? Well we are not being very thoughtful about this. We
have actually seen this movie before though maybe it was a shorter
version.

Remember the S & L crisis and the Resolution Trust
Corp? I do because I hit a very, very good lick in purchasing
distressed properties from the RTC, pension funds, insurance companies,
banks and S & Ls. I bought them for $0.20-0.30 on the dollar of
replacement cost, fixed them up, owned them for about 5-7 years, had
the numbers audited annually and sold them all to institutions in 3
transactions in 1995 — 6,000 apartments, 100 warehouses, 7.5 MM sf of
offices.

My partners were the likes of GE Capital (for whom I
also fixed up some of their problems), Fidelity and private foreign
investors. BTW, GE Capital is the smartest bunch of real estate folks I
ever met and the best risk takers a partner could ever have hoped for.
And they made a ton of money in the deal while conducting themselves
like perfect partners and gentlemen. Private money jumped in big time!

I’ve heard that the hedge funds who made the most money on the "short subprime trade" have largely unwound that trade and are starting to nibble at the very mortgages they bet against a couple years ago. That’s a good sign and this splurge is going to allow them to do more than nibble shortly.

So, here’s the point I want to make. I would like the splurge legislation to require that we not only have public disclosure, but that we have in effect a real time listing (like the Nasdaq) of all splurge related transactions. This is good for the public (so we know what’s going on with our money) and it’s good for the Treasury (so it is forced to behave rationally) and it’s good for investors who want to profit from all of this splurge activity. It will also allow us, after the whole things is over, to analyze the splurge and learn from it, like JLM learned from the RTC.

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This may come off as a shameless plug for one of our portfolio companies but I hope not because it isn’t intended as such. With the tough economic times we find ourselves in, many people will be tightening the hatches this holiday season and will be looking for a way to buy gifts that are nice but also affordable.

Etsy is well known as a place to find handmade, one of a kind, artistic and "crafty" items. It has great appeal to a certain sensibility but has not really caught on yet with the mainstream user. Etsy’s CEO, Maria Thomas, mentioned in her web 2.0 talk that Etsy is doing about $100mm in annual sales right now. It’s a big business, but not yet a mainstream business. That might change when people find out that you can get lovingly made, beautful, one of a kind gift items for way less than you’ll pay for something equivalent (if that’s even possible) at Wal-Mart.

Here are some examples:

A wood train set for $89.95 that includes six cars. Handmade in the seller’s wood shop.

A cute pinafore dress for a little girl that costs $24.

A plush dog toy for $16.

A necklace for $34

These are just four items I found in about ten minutes of poking around Etsy.

They are one of a kind and if someone buys them between now and when I post this on Monday morning, they might be sold out.

But my point is not to try to sell these four items, it’s to point out that there are wonderful gift items for really great prices on Etsy. I hope that more people learn about Etsy this holiday season because it will help people save some money and put some great gifts under the christmas tree or hanukkah bush at the same time.

I use Facebook a bit, but I use Twitter more. It’s surely because of our investment in Twitter. But it was like that before our investment in Twitter. It could be because the people I connect to most often are on Twitter. It could be because I don’t have to log in to Twitter every time I want to use the service. Regardless of the reasons, that’s how it is for me right now.

I do have an active social net on Facebook (317 friends all of whom I know, and there are another 719 friend requests pending) and lately I’ve been getting a fair number of emails from Facebook that look like this.

Tom commented on your status:

Yeah man, the Mets – what a killer ride – does it crash?

To see the comment thread, follow the link below:
Thanks,The Facebook Team

Tom was replying to my twitter post yesterday about the Mets. He saw it in Facebook and replied to it in Facebook. I got it in an email from Facebook.

Contrast how this works on friendfeed. If Tom had seen the Mets post on friendfeed, his interaction would look like this:

He could have replied directly in friendfeed and had it also posted to twitter, where I could see it along with all of my other replies.

When I visit the status update page on Facebook these days, it’s filled with twitter updates. Here’s what mine looks like this morning.

Four of my first six status updates in Facebook come from Twitter and 30 of the 50 status updates on the page come from Twitter. It’s no wonder that my kids, who use Facebook exclusively and have never even tried twitter, call status updating "twittering".

So I think it would be great if Facebook copied friendfeed’s implementation of replying back to a twitter post via Facebook. That would help me out a lot.

Of course, they could take this even farther if they integrated completely with twitter by letting me reply back to Tom via twitter into his Facebook feed.

Some people will want to twitter on twitter, some will want to do it on Facebook, some will want to do it on friendfeed. What we need to do is make sure all these services talk to each other so we, the users, can talk to each other.

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I watched the debate last night like many other americans. Although the nationwide numbers aren’t available until monday, it appears that about 40% of americans watched last night. That’s bigger than any of the Bush debates and possibly even bigger than the 38% that watched Clinton/Bush in 92. I heard today that over 40% would be in super bowl territory. It’s clear that americans are tuned in to this election.

But what really got me thinking was how the foreign policy debate between McCain and Obama last night was broadcast to the entire world. The russians got to see them debate our policy toward Russia. The iranians got to see them debate our policy toward Iran. The chinese took notice of our concern about our economic reliance on China. And so on and so forth.

I am proud to live in the most open transparent democracy in the world. Yes, we have huge problems in this country. Yes, we need to change the way we are operating in this "post american world" we find ourselves in. But we have the courage to conduct our debate in the open in public and broadcast it to the rest of the world. And that’s a great thing.

The banking system we have today is financial infrastructure similar to the old phone networks in preInternet days – it’s way too centralized and too many tolls are paid as the flow goes through the money centers.

Interestingly the $100,000 limit on FDIC insurance is encouraging people to move their assets out of the money centers and directly into regional and local banks.

The pain of transition to a less centralized and less intermediated financial system will be great but hopefully less than the cost – not only in funds now but efficiency later – of keeping the old infrastructure in place.

Originally posted as a comment by Tom Evslin on A VC using Disqus.

I went to bed with the news that McCain wasn’t sure if he would support the splurge. Not that anyone needs my vote on this thing, but I woke up trying to figure out if I am in favor of it. So I’ll read (links) and think outloud and hopefully get somewhere.

My friend Tom Evslin, a conservative in the best sense of the word, posted his thoughts titled Just Say No. He argues the splurge is a short term fix and we should invest the capital in long term solutions to our economic problems instead.

My friend Roger Ehrenberg, a wall street guy who made the leap to startups and VC a few years back, thinks we must do something:

Bottom line, I think the system would remain too jammed for too long
simply letting things play out on their own. Now I am a free markets
guy. I grew up in the markets. Love the markets. Believe in the
markets. But this market is badly broken, and it needs a bridge loan to
begin the healing process. And this can and must be structured in a
manner that achieves the objectives without unfair and inappropriate
bailouts. The devil is in the details. But to toss aside the call for
action is, in my opinion, playing a dangerous and unnecessary game.

Mohamed El-Eria, Co-CEO of the huge bond fund PIMCO, wrote this in the FT yesterday:

As is now widely recognised, left to their own devices, US financial
markets simply could not accommodate the large and simultaneous
shrinkage of multiple balance sheets without major damage to
institutions and, critically, the system. Last week, the damage had
migrated to the essential component of any financial system – the
smooth functioning of cash, collateral and counterparty risk management.

You
would think all this would be too arcane for the politicians to take
notice until it was too late. Yet they did because disruptions affected
money market funds and, as such, became a real and present danger to
the average American. In these circumstances, the authorities had no
option but to act urgently. They did so by coming up with a bold and
targeted multifaceted approach. In the process they made two
transitions that are key to successful crisis management: most
importantly, move away from piecemeal measures and towards a
comprehensive and self-reinforcing policy programme; and see internal
measures supported by some action by other countries.

I am persuaded by Roger and Mohamed’s arguments that there is just not enough liquidity in the system and it needs a "bridge" and the lender of last resort is all of us, the US taxpayer.

But when a venture backed company runs into trouble and needs a "bailout" from its investors, the investors who step up generally get all the upside (with a generous carveout for the management team that will take the company forward). And when they are done right, these "recaps" (or "cramdowns") can be very profitable for the investor of last resort.

Look at what Buffett did with Goldman Sachs. He got a $5bn investment at what looks like an attractive valuation, he got preferred stock so his money gets out before any other equity holder, he gets a 10% interest rate, and 100% warrant coverage in the money. That’s the kind of deal the investor of last resort gets.

I do believe that the "splurge", as I’ve been calling it, can be structured as an investment of the taxpayer’s money into the fragile banking and brokerage system. And I am thrilled to see that someone on capital hill is smart enough to tranche the money as we would do in the venture business. Why invest $700bn when you can start with a couple hundred billion and see how its going?

What I want to know is what our upside is on this deal? We’ve been talking about $700bn which is what we call "the total capital requirements" or the $250bn which is what we call "the first round". At $700bn, that is $2300 for every citizen of the US, a huge sum for most people.

What I have not seen is a probability adjusted set of outcomes and an expected value of the gains on this investment we are being asked to make. If this money is not coming back, then its an expenditure and we should not do it.

If the probability adjusted return on this investment is $1.5tn then we should do it in a nanosecond. We would not approve any investment without doing this work and neither should our government. If I were Bush, McCain, or Obama (all three of them ideally) I’d send Paulson and Bernake to their cubicile and tell them to do the numbers and come back with the return projections before voting on this.

That’s my two cents for what it’s worth.

UPDATE: The comment thread on this post is what all comment threads should be, an informed honest tough conversation about this issue. I highly recommend it and want to thank everyone who has weighed in so far.